1. Field of the Invention
The present invention relates generally to financial instruments, and more particularly, relates to a specific allocation of principal payments for securities with structured cash flows, such as, but not limited to, structured mortgage-backed securities, securities based on account receivables, student loans or credit card receivables.
2. Related Art
In the mortgage market, consumers (or borrowers) purchasing a home usually borrow funds from a lender (e.g., a bank, finance company or the like, who are also called “originators” or “lenders”). As is well known in the relevant art(s), the legal document by which the mortgaged property is used to guarantee repayment of the loan is known as a mortgage (or mortgage loan).
In order to have funds to meet additional consumer demand for home mortgages, lenders generate and liberate capital by selling the mortgages they originate into the secondary market, keeping the supply of money for housing more widely available and ultimately lowering costs to borrowers.
The majority of mortgages sold into the secondary market are sold directly or indirectly to the Federal Home Loan Mortgage Corporation (“Freddie Mac”) or the Federal National Mortgage Association (“Fannie Mae”), although some are sold to other market conduits. In order to generate funds to buy more mortgages, these secondary market entities create securities backed by the purchased mortgages. These securities, which in their most basic form, pass through the borrowers' payments to investors are referred to as “mortgage pass-through securities” or mortgage-backed securities (“MBS”).
MBS serve only a segment of the mortgage-backed securities market. Other investors, including many institutional investors, purchase or hedge in securities backed by MBS, or securities that are resecuritized. In its simplest terms, a resecuritization means that a new security is created using another security as the underlying collateral; in much the same way that mortgages are the underlying collateral for MBS, MBS are often the collateral for another mortgage-related security. These resecuritizations may be combined (sometimes several times) into various structures that are layers removed from the original mortgages and even the MBS. Each security, however, is based directly or indirectly on the income stream of borrower mortgage payments.
These structured securities typically have complex rules for payment allocations to investors. An example of a structured transaction known by those in the relevant art(s) is a Real Estate Mortgage Investment Conduit (“REMIC”). A REMIC is comprised of multiple classes of mortgage-related securities in which cash flows from the underlying collateral are allocated to individual “classes” (sometimes called “bonds” or “tranches”) with varying maturities and principal and interest payment priorities. REMICS are popular transactions within the mortgage investment industry because of their flexibility in structuring mortgage payment cash flows to suit specific investor risk and return thresholds related to these risks.
Investors in any mortgage-related security are exposed to a number of associated risks, including prepayment risk and reinvestment risk, in addition to the usual risks associated with investment in securities. An investor in a REMIC tranche may base its investment decision upon (i) maximizing static yield (i.e., the annual percentage rate of return earned on a security) without regard to reinvestment risk, or (ii) risk-adjusted returns (as described below).
As will be apparent to those skilled in the relevant art(s), the following discussion applies not only to mortgage-related securities, generally, but to other structured and asset-backed securities as well.
The weighted average life (or “WAL”) of a security refers to the average number of years that the security is outstanding (i.e., until a investor receives its final payment on that security). The WAL of a particular class of an asset-backed security, such as a mortgage-related security, will depend primarily on the rate of principal payments—a combination of scheduled payments and unscheduled payments (or “prepayments”)—on the underlying assets.
WAL variability of a mortgage-related security is driven primarily by prepayments. A prepayment on a mortgage occurs whenever a borrower exercises its option to prepay, partially or fully, a mortgage at any time. Prepayments, which result from voluntary or involuntary sales of homes, refinancings or any other unscheduled principal payments, are difficult to predict because borrower behavior is difficult to predict.
Prepayment risk is closely related to reinvestment risk. When prepayments occur and an investor's investment is returned as a result, the investor is exposed to reinvestment risk (i.e., the risk of investing funds at a lower rate of return and/or with a different risk profile). For example, in a declining interest rate environment, the returned funds likely will be reinvested at lower rates, reducing the investor's investment yield, assuming the investor wants to remain in investments with comparable risks. In fast prepayment environments, investors may fail to recover any premiums paid when they purchased their mortgage-related securities because their principal is returned at par value (i.e., face value or the amount that the issuer agrees to pay at the maturity date). For example, an investor may pay $103 for a security with a $100 principal amount, but if the security prepays, the investor will receive only $100 in principal.
The description of the following embodiments of the present invention focuses on principal payments, although most, but not all, mortgage-related securities have both an interest and principal payment component. The interest, however calculated for a particular class of securities, is generally calculated on the basis of the then-outstanding principal balance of the security, which is in turn based directly or indirectly on the then-outstanding balance of the underlying mortgages.
It is a challenge to structure cash flows from these underlying payments that efficiently fulfill investors' yield requirements, taking into consideration differing investor risk postures, or willingness to invest in cash flows with more or less WAL variability. Prevailing interest rates are the leading indicator for predicting prepayments. Predicting when a borrower may elect to exercise its option to prepay its mortgage obligation is an uncertainty at all times, however, and among other risks, manifests itself in two major risk scenarios.
Call risk is a specific risk typically associated with declining interest rates. When interest rates decline, the borrower may choose to exercise the right to prepay its mortgage, perhaps through refinancing, and take out a mortgage at a prevailing lower rate. In this scenario, the investor would prefer that the borrower not refinance or otherwise prepay the mortgage because the investor is getting a higher interest rate return than current market. Any full or partial prepayments by the borrower are passed through to the investor, who must then reinvest those funds, presumably at prevailing lower market rates.
On the other hand, extension risk typically exists when interest rates increase. The borrower may choose to pay the mortgage according to the original amortization schedule (and correspondingly lower rate) or repayment term (e.g., 30 years), effectively extending the full repayment of principal as long possible over the term of the loan. The borrower has no economic incentive to prepay early or refinance and borrow funds at higher rates. In contrast, the investor would prefer that the borrower prepay the mortgage early in this situation so that the funds could be reinvested at prevailing higher market rates. For an investor, this scenario creates a risk of extending the investment longer than anticipated, based on the predictions described above.
In the relevant art(s), certain structured securities (e.g., REMICs) are used to address investor call and extension risk. For example, REMICs distribute cash flows received from the underlying mortgages and mortgage-related securities through the various REMIC classes, designed to redistribute the risks along with the cash flows in accordance with investors' needs and risk tolerances. Each class within a REMIC has its own payment priority (which may shift under certain scenarios), which determines, to the extent possible, whether the WAL variability of a particular class will be more or less stable (or have more or less predictable risk).
Prior mortgage-related securities structures have attempted to address the above-described investment risks in structures designed to provide call and extension risk protection. For example, previous REMIC securities offerings have used generic non-accelerated security/accelerated security (NAS/AS) Classes in their structures. In those structures, the NAS Class usually received principal payment allocations more slowly than its underlying collateral in the early stages of the transaction's cash flow stream, with the percentage of payments allocated to the NAS Class increasing over time. Since payments on a NAS Class are linked to payments on one or more AS Classes, the AS Class(es), conversely, received a greater allocation of principal payments in the early periods. NAS and AS Classes redirected principal payments from and to each other at varying rates as a function of time only.
Prior structures using NAS/AS Classes, however, did not provide NAS Class investors with call risk protection during later payment periods or fast prepayment scenarios. In other words, NAS investors could receive a return of their investment earlier than anticipated if prepayments on the underlying mortgages accelerated.
Given the foregoing, what is needed is a method for allocating principal payments for mortgage-related securities that more effectively addresses the above-described risk scenarios with a more defined distribution of prepayment and reinvestment risks.